Stripped MBS – Interest Only (IO) and Principal Only (PO)
Mortgage backed securities can be stripped into principal only (PO) strips and interest only (IO) strips. The principal component of the MBS payment is used to pay down the PO strip MBS, while the interest component of the payment is used to pay the IO strip MBS.
The bonds of stripped MBS therefore do not have a pro-rata principal and interest payment distribution to investors.
PO strips receive the entire mortgage principal and only the mortgage principal.
- PO strips have a known dollar amount but an unknown timing.
- The PO strip will be sold to investors at a significant discount to the gross principal balance; the discount amount will be based on the level of interest rates and the prepayment speed.
- Generally, PO strip bonds are more volatile than conventional MBS.
- Declining interest rates increase PO repayment speed, lowering the discount rate and increasing the PO price.
- Rising interest rates cause prepayments to decelerate and increases the discount rate applied to cash flows, thus lowering the PO price.
- The yield on PO strips varies based on the prepayment speed. The higher the prepayment, the faster the principal is repaid, and the higher is the yield for the investors.
- The investor is protect from the contraction risk.
IO strip investors receive only the interest component of the mortgages in the security pool.
- Assuming that a mortgage is held to maturity, the IO payments would be very high in the early years and very low in the later years.
- High prepayments tend to reduce IO values.
- As interest rates decline and prepayments increase, less dollars of interest are paid to IO investors, so IO prices can drop when interest rates decline.
- As interest rates increase, prepayments decrease, so mortgages last longer and the total dollars paid to IO holders rises; therefore IO prices can rise when interest rates rise.
- Collateralized Mortgage Obligations (CMO) and CMO Tranches
- Stripped MBS – Interest Only (IO) and Principal Only (PO)
- Residential Non-Agency MBS
- CMBS: Structure and Call Protection
- Amortizing Loans vs. Non-Amortizing Loans
- Overview of Asset Backed Securities (ABS)
- Internal and External Credit Enhancements
- Pay-through Structures: Prepayment Tranching vs. Credit Tranching
- Home Equity Loans (HEL) Backed Securities
- Manufactured Housing Backed Loans
- Auto Loans Backed Securities
- Student Loan Backed Securities (SLABS)
- SBA Loan Backed Securities
- Credit Card Receivable Backed Securities
- Collateralized Debt Obligations (CDOs) and Synthetic CDOs
- Cash Flow Yield, Nominal Spread, and Zero Volatility Spread for ABS/MBS
- Monte Carlo Simulation for ABS/MBS
- CFA Level 2: Fixed Income Part 2 – Introduction
- Duration and Convexity for ABS/MBS
- Mortgage Cash Flow Characteristics
- Choosing an Appropriate Spread for ABS/MBS
- Mortgage Pass-through Securities: Characteristics and Risks
- Cash Flows and Prepayment Risk
- Single Monthly Mortality (SMM) & Conditional Prepayment Rate (CPR)
- PSA Prepayment Benchmark